Will The Real Inflation Please Stand Up? Why Paying Attention To Asset Price Inflation Is Important For Investors
By now pretty much everyone knows that the massive amount of financial stimulus from the central banks and the government has bid up all asset prices. But the Fed and the rest of the central bank community vehemently denies, at least publicly, that the seeming froth in all markets (stocks, bonds, credit, real estate…) is anything to worry about, as long as there is no inflation.
In particular, they are now all leaning on Modern Monetary Theory (MMT) which says that as long as there is no inflation, a sovereign government can, and should, print unlimited amounts of money to solve economic, financial and social problems. And to prove there is no inflation, they point to the CPI (Consumer Price Index), PPI (Producer Price Index) and PCE (Personal Consumption Deflator). It is not important that the reader know the details of these indicators other than that none of them have financial asset prices in them. In other words, they monitor price increases in the cost of a carton of milk or a dozen eggs, not the value of a house or a security.
But shouldn’t asset price inflation be included in the inflation metrics? One rationale to include it would be that folks with the ability to own financial assets (generally the “rich”) primarily use asset prices to store value. In the future, when they might need the money, they can liquidate some of the assets to pay for ordinary goods and services. Thus excluding asset price inflation is like saying that the only thing that matters for people’s lifestyle decisions is what they will consume today and tomorrow, and maybe the next year. It also assumes ordinary people are not very smart, and they are short-sighted on how they make decisions based on prices. For someone who has assets, it is simply commonsense that if push came to shove, they could, or would, sell some of these assets to pay for food, gas, shelter etc. At least that’s the way I think I would respond.
Almost fifty years ago a relatively unknown paper by Armen A. Alchian and Benjamin Klein was written with the simple title “On A Correct Measure of Inflation”, making essentially this same argument. Alchian and Klein started with the assumption that ordinary people are neither myopic nor stupid, and indeed do make decisions considering the possible outcomes even in the distant future; i.e. a lifetime approach. Yes, they are not perfect, but to ignore that they consider the longer term outcomes of their choices just does not seem accurate.
This exhibit shows the consumer inflation rate as measured by the PCE in green, and an adjusted inflation rate using the Alchian-Klein approach of weighting inflation with asset price growth rates for different weights. The asset price adjusted metric is more volatile than the “pure” consumer inflation metric. Source: LongTail Alpha
One big technical problem with including asset prices in inflation metrics is that since asset prices are very volatile, they would make the inflation metrics very volatile (see chart below), making it much harder for policy makers to observe one number that they can then target with real-time monetary policy, such as raising or lowering interest rates. Also many things are indexed to the inflation metric, so a volatile metric would make book-keeping of these obligations very messy (averaging may be able to help, however). But that’s the nature of the beast and making one or two metrics paramount over everything simply ignores the complexity of the real world, a world in which asset ownership is becoming more democratized. We cannot simply choose a simple metric because it makes our life easier, especially if the welfare of the world depends on it. Including asset price inflation in traditional inflation metrics makes the metric more noisy, but is this a good reason to continue ignoring asset price inflation when both the Fed and the economy respond to asset price inflation and deflation? When it comes to social costs, oversimplifying the complex is a recipe for disaster. As the saying goes: “not everything that is worth measuring is measurable, and not everything that is measurable is worth measuring”, and if asset prices are an important driving factor for the economy, financial stability, and Fed response, I believe it should be given more importance in the metric that sets policy.
In the infatuation with precise measurement the real inflation baby has been thrown out with the bathwater. I sense some physics envy from macro-economists in their effort to make economics like Newtonian physics with a few simple equations. But since people with moods, manias and panics make the economy and the markets, not inanimate unthinking atoms and molecules, it seems silly to try to boil economics down to physics.
In practice, the markets already know that the Fed is targeting stock prices even though they are volatile. A precipitous decline in stock prices creates fear, and could lead to deflation, recession and maybe even depression. The answer has been to deal with the fear of economic recession with financial repression. As the unswerving support for keeping interest rates low and asset purchases remains on auto-pilot, savvy investors have already started to build protection for the ultimate unwind and pivot. Investors know that at some point, not too far off, real inflation could catch up to asset price inflation, or asset prices could catch down to a deflating economy and when that happens, the Fed will have to scramble to catch up. And yes, if a correlated stock and bond market meltdown results in deflation in asset price adjusted metrics of inflation, the Fed will most likely have to take rates negative and buy even more assets, perhaps even stocks. That’s the way it always works.
For now, policy makers have started to paint themselves into a corner. The problem with being cornered is that the only way out is an unpredictable action. Markets are getting ready for this and smart investors will begin to build some serious defense in their portfolio. Either that or ride it out and hope, like with March 2020, the markets bounce back in a reasonable time. As usual, it’s important to remember that you cannot get something from nothing. If we are dreaming of rising asset prices to the moon without something going wrong in the economy sooner or later, don’t blame faulty metrics. And don’t depend on the Fed to bail us out again and again. One advantage of mis-specified inflation metrics is that for those who can see through the mirage, opportunities abound.